Expanding bond market, developing futures market

Bond market, as one of the pillars of the financial market, links the issuers having long-term financing needs with investors willing to place funds in long-term interest-bearing securities.  The market helps allocate savings and decide on the optimal use of money and also provide an avenue for raising capital mainly for the private sector, the government and public sector units.  When firms can raise funds by issuing bonds, they are less dependent on banks and less exposed to vulnerabilities of the banking system. It also makes the financial market more competitive by generating market-based interest rates that reflect the opportunity cost of funds at each maturity and reduces excess dependence on the banking system.
Bond is a debt instrument issued for the purpose of capital borrowing for a specific period of time and it is fixed-interest financial tool issued by the government, corporate and other large entities. The size of debt market of Bangladesh is small as compared to other SAARC countries.  This market in Bangladesh has been found inadequate with respect to the number of issues, volume of trade, number of participants, long-term yield curve, interest rate policy etc.
An efficient bond market can play a critical role in supplementing the banking system to meet the requirements of the corporate sector for long-term capital investment and asset creation, but it needs required policy to grow. It can provide a stable source of finance when the equity market is volatile. While the size of tradable government bonds is small, its secondary trading is rare and there has been rarely any public issue of corporate bonds in the country's bond market.
A well-functioning bond market offers the borrowers flexibility to diversify their sources of funding and provides them with alternative sources of raising funds having different credit risks and maturities for matching expenditure needs.
The bond market in the country is only 16 per cent of the total financial market while the banking sector covers about 63 per cent, stock market 20-25 per cent and the remaining the insurance market. The scenario is different in other Asian countries.
Presently two kinds of government securities - treasury bills and treasury bond - exist with different maturity periods with the former with less than one year and the latter with 2, 5, 10, 15 and 20 years of maturity periods. Treasury bills and bonds are issued through an auction process where the allotments are awarded to the bids which fill the notified issue amount ranging from the lowest to the highest yield. Pro-rata partial allotments are made for bids at the cut-off yield. The Bangladesh Bank (BB) uses these indirect monetary policy instruments for debt management purposes. Treasury bills and bonds are actively used by the BB to mop up excess liquidity and to provide a mechanism for financing government deficit. Treasury bonds are auctioned every month following pre-announced auction calendar prepared by the BB and the ministry of finance considering liquidity and macroeconomic indicators. In order to improve liquidity and assets-liabilities matching, 2-year BGTB, as a new instrument, has been in auction since May 28, 2013.
Banks are eligible to use the government treasury bills and Bangladesh Government Treasury Bonds (BGTBs) for Statutory Liquidity Requirement (SLR) purpose. These bills and bonds are eligible for secondary trading. Fifty-nine auctions of these instruments were held in FY14.
The secondary market for government securities is still not active. The BB periodically conducts secondary trading and also buys back the securities as per instructions of the government. Trading volume in government securities is currently negligible. To activate the market, it is necessary to push institutions (banks and other financial institutions) to encourage a culture of trading, develop safe and efficient trading and settlement systems, sensitise market participants to internalise effective risk management practices and stabilise market standards.
The Business Initiative Leading Development (BUILD) conducted a small study in June 2015 to find out ways to expand the bond market and increase effectiveness of tradable bonds, specially BGTB and treasury bills, in the economy to identify the problems faced by primary dealers' associations and other institutions in dealing with BGTB and treasury bills. The study was presented in its 5th financial sector working committee meeting held in June and co-chaired by the Deputy Governor of the BB and it suggested some policy reforms.
In order to develop the secondary bond market as a new window of investment for banks and financial institutions, the BB has created an alternative platform exclusively for primary dealers (PDs) to promote transactions of government bonds in the stock exchanges. The Securities and Exchange Commission (SEC), on the other hand, plays its part by guiding and encouraging selected brokerage firms to take part to activate trading of government bonds. Primary dealers are selected to perform as market makers for government securities. They act as underwriters of government securities at the primary auction. This helps the government to raise money from the market at a reasonable cost. Whenever the government/BB finds the interest rates for government securities unacceptable at primary auctions, it can collect the required amount from PDs. This reduces the borrowing cost for the government.
A few factors act as constraints for bond market such as lack of benchmark bonds, inadequate regulatory system, market distortions and a lack of interest from private companies in bond markets because of high costs. The secondary market of the country is illiquid which hampers the proper pricing of treasury bonds in the primary market. Previous records in default of debentures are also responsible for the slow growth of the bond market.  Obscure regulatory requirements and a long approval process are the other reasons of the poor state of government bond market.
The banks and PDs are required to keep their Statutory Liquidity Ratio (SLR) up to 13 per cent and Cash Reserve Ratio (CRR) at 6.5 per cent, thus making it total 19.5 per cent. This has reduced the loanable funds of banks. But in case of non-bank financial institutions (NBFIs) they have to keep their total CRR at 2.5 per cent, SLR 2.5 per cent totalling 5 per cent. The NBFIs can use FDR as SLR which is not allowed for banks. The NBFIs can maintain the SLR from government securities, call for loans and balance with other banks but for banks the sources are different. Maintaining components of SLR of banks and NBFIs could be similar.
If the pension, provident and superannuation gratuity fund can be invested in the government securities, then bond market will be expanded. These sources can be helpful as alternative sources of funding. A certain amount of pension fund, provident fund, superannuation fund, gratuity etc. of nationalised corporations, private corporate/enterprises registered with the sub- register and acknowledged by the NBR (Commissioner of Taxes) may be invested in the government securities as per the Trust Act. A national central institution to supervise all kinds of funds like pension fund, provident fund, superannuation fund, gratuity etc. may be established and formulate necessary rules and regulations to invest the fund in government securities. The secondary bond market trading should be encouraged by making trading of the government bonds by primary dealers and allowing all government bonds to be accepted as collaterals by the central bank.
Different insurance companies like ALICO buy a good amount of bonds every year but they may invest up to 30 per cent of their life fund as per the Insurance Act. Bonds seem to be very illiquid as they have a fixed maturity date; the BB should allow Special Repo, Assured Liquidity Support (ALS) etc only for banks. It should be at least 30 per cent for the insurance companies. Liability of insurance companies is long term so that they should invest their funds in longer maturity funds. Minimum 30 per cent of life fund of life insurance companies may be invested in government securities instead of existing regulation of maximum 30 per cent. If the new provision is introduced, an insurance company, if it wishes, can invest more than 30 per cent.
Yield of government securities is normally lower than that of the cost of fund of PDs. So to mitigate the losses especially excess holding and with a view to developing government securities, tax on interest income of PD operations may be exempted. Information dissemination of bond market should be made properly as information on outstanding stock is only known to the central bank.
In a Statutory Regulatory Order (SRO) issued in 2005, the government offered tax-free facility on income of the companies, authorised by the Bangladesh Securities and Exchange C omission (BSEC), from investment in the zero coupon bonds. For long-term investment, the government policies should be stabilised and  should not be changed every year.
STRIPS, which stands for Separate Trading of Registered Interest and Principal of Securities, can work when principal and coupon interests are separate, and then principal of the bond is treated as zero coupon bonds like existing treasury bills. The pricing of new bond is based on the present value of all future cash flows.  Income from principal part of striping bond (zero coupon bond) may be exempted from income tax like capital gain from sale of government securities as and when it will be introduced.
Development of an organised futures market will help promote market liquidity and efficient pricing in the secondary market. If pension, provident and superannuation gratuity funds can be invested in government securities, it will be safer for organisations, employees and retired people. Insurance companies will be benefited by investing their funds in longer-maturity funds as liability of insurance companies are long-term as they will remain secured.

The writer is CEO, Business Initiative Leading Development (BUILD).
ceo_build@outlook.com